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Has Demand Media Become the Perfect Stock?

The Internet-content company faces some severe competition.

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Demand Media (NYSE:DMD) fits the bill.

The quest for perfectionStocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.

Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.

Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.

Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.

Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.

Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Demand Media.

Factor

What We Want to See

Actual

Pass or Fail?

Growth

5-year annual revenue growth > 15%

22.8%

Pass

1-year revenue growth > 12%

17.1%

Pass

Margins

Gross margin > 35%

52.4%

Pass

Net margin > 15%

1.6%

Fail

Balance sheet

Debt to equity < 50%

0.3%

Pass

Current ratio > 1.3

1.46

Pass

Opportunities

Return on equity > 15%

1.4%

Fail

Valuation

Normalized P/E < 20

120.29

Fail

Dividends

Current yield > 2%

0%

Fail

5-year dividend growth > 10%

0%

Fail

Total score

5 out of 10

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at Demand Media last year, the company has kept its five-point score. The stock has done fairly well, rising 20% over the past year as the company has gone from a year-ago loss to a modest profit.

As a producer of basic Internet content, Demand Media has sought to capitalize on the explosion in information available online. This time last year, the company seemed to be on the verge of a buyout from a private-equity company, but Demand Media reportedly rejected the initial offer and it eventually fell through.

Since those buyout rumors proved untrue, Demand Media has seen its share price slump. Much of the problems comes from the fact that the company is part of an arms race in the search space, and AOL and IAC/Interactive (NASDAQ:IAC) are competing with Demand Media to try to capture search-engine optimization share on certain valuable keywords. As if heightened competition weren't bad enough, Demand Media has to deal with the constant threat that Google and other search providers will change their search algorithms, basically undoing all their work.

In its latest quarterly report, Demand Media provided favorable future guidance and solid earnings. But of even more interest to investors was the idea of splitting into two parts, with one company focusing on web services like domain registration and the other working to create and monetize content.

For Demand Media to improve, it needs to demonstrate its competitive advantage in the content space while also working on being more efficient in turning its growing revenue into profits. If it can succeed at that, then Demand Media could get closer to perfection in the near future.

Keep searchingNo stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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